Total Impact - How regulation and crisis management will change the world’s financial landscape

Dr Andreas Dombret
Member of the Executive Board of the Deutsche Bundesbank

1 Introduction

Ladies and gentlemen

I am delighted to conclude this year’s Frankfurt Finance Summit. For
the third year in a row, this event has provided an excellent platform
for an exchange of views between high-level experts from politics,
academia, as well as the financial and the official sectors to discuss
financial market issues of major current importance.

Today’s conference has been asking about the total impact that
regulation and crisis management will have on the financial landscape.
The keynote speakers and panellists have given wide-ranging and, in some
cases, diverging answers to that question. I am pleased to conclude
this year’s summit by offering my views on some particular aspects of
the issues discussed today.

2 Future of the European Monetary Union

Let me start with the topic of the first panel this morning: the
future of European Monetary Union. The crisis has highlighted
shortcomings in the Union’s institutional framework. Let me remind you
of three serious flaws.

First, the deficit rules of the Stability and Growth Pact were not
only circumvented by some member states, but deliberately bent.

Second, member states’ borrowing was not effectively curbed because
financial markets failed to exert a disciplining effect on public
budgets.

Third, contagion effects transmitted via member states’ financial
systems were largely underestimated. The introduction of the single
currency led to a greater integration of European financial markets. The
highly integrated market increased the probability of contagion effects
occurring via member states’ financial systems. Hence, it amplified the
existing close link between risks stemming from a country’s public
finances and the state of its banking system.

These flaws were a major factor in the emergence of the sovereign
debt crisis and that fact makes a good case for strengthening the
institutional framework of the monetary union. I welcome the measures
that have been initiated. The reform of the Stability and Growth Pact
and the agreement on the Fiscal Compact are major steps towards sounder
budgetary policies. With the agreement on a European banking union, we
have made further progress in one important specific area.

A banking union can help to strengthen financial stability by
loosening the nexus between banks and sovereigns. A European banking
supervisor would benefit from the ability to make cross-border
comparisons, for instance. Such a body should be able to monitor the
build-up of excessive risks and pinpoint them more easily and at an
earlier stage. A single supervisory mechanism should also overcome the
national bias of supervisors.

But a single supervisory mechanism is not sufficient. To shield banks
from weak public finances, it must be accompanied by a sound regulatory
underpinning. Such regulation should include upper limits for lending
to governments and appropriate capital backing for sovereign bonds.
Finally, a banking union should comprise a European resolution and
recovery mechanism to ensure that bank creditors – and not taxpayers –
are the first in line to bear losses from a bank’s failure.

Such a comprehensive banking union will be an important element of
the new institutional framework of the monetary union. It will bring
about significant changes not only for banks and their stakeholders, but
also for regulators and supervisors with functions being transferred
from the national to the European level.

3 Financial sector reforms

Changes will also be made through financial sector reforms. The
financial crisis has highlighted weaknesses in financial sector
regulation. As a response to this, the G20 Heads of State or Government
set in train a comprehensive reform agenda in November 2008.

In the meantime, we have passed a number of major milestones on that
agenda. But to make the international financial system as resilient and
robust as it should be, we still have a long way to go.

One of the most pressing issues is the implementation of Basel III.
What is most worrying is that doubts about implementation have been
voiced with respect to countries that are home to global financial
centres and systemically important institutions. I consider it of utmost
importance that all G20 countries live up to their self-commitment of
leading by example. The initial implementation timelines have been
modified in the EU and the US. We need to make sure that such delays do
not lead to a watering down of the measures that we agreed upon
internationally.

Stricter banking regulation might set incentives to move business to
less regulated entities. The regulation of the shadow banking system is
therefore another pressing issue. Regular monitoring exercises help us
to gain a better understanding of the kind and scale of business
conducted outside the regulated banking system. But its actors and
activities still remain largely unregulated. I consider it particularly
important to deliver a final set of integrated recommendations on
regulating the shadow banking system to the G20 in September.

And it is absolutely crucial to finally solve the too-big-to-fail
problem. However, we have to keep in mind that this term is not very
precise. In many cases, institutions were not too big but actually too
important to fail. Recent examples of nationalisations and repeated
bail-outs of institutions in the Netherlands and France show that,
ultimately, it is still the taxpayer who is at risk when banks are in
trouble. We need to remove the implicit government subsidy for
systemically important institutions and subject them to the ultimate
sanction of the market. It must be possible to force banks to exit the
market without destabilising the financial system. To make this threat
credible, we have to restore a constitutive element of any functioning
market economy: the principle of liability. The one who profits must
also be the one to bear the losses. I consider the implementation of the
internationally agreed framework for dealing with systemically
important financial institutions as a top priority.

Similarly, a ‘too big to fail’ issue – but this time in the truest
sense of the word – can also occur if the banking sector is too large in
relation to the economy as a whole. The cases of Iceland, Ireland and
Cyprus are good examples of this. The banking system in Cyprus is
currently about 7 times the size of national GDP. By way of comparison,
an average banking system in the monetary union is 3.5 times the size of
national GDP. This problem has also been fuelled by the Cypriot
business model of providing a low-tax environment.

If the banking sector is too large, the national taxpayer will be
unable to bear the costs. Consequently, European solidarity will be
required to resolve the problems. This is comparable to the case of
systemically important banks, which depend on the support of the
taxpayer if the bank gets into difficulties.

This is why the problem of banking sectors that are “too big to fail”
also needs to be addressed one way or another. This could be achieved
by downsizing the banking sector, as agreed at the meeting of the Euro
Group.

But let me get back to the current reform initiatives. They need to
be fully and consistently implemented to enhance the resiliency of the
financial sector. To ensure consistency, we need to focus even more on
the systemic aspects of financial regulation. Regulatory measures must
build upon each other and be interlocked to set consistent incentives.
Otherwise, we run the risk of individual measures conflicting with each
other. Such a lack of consistency might lessen the desired effects of
the new regulations or even negate them entirely. Impact studies are an
important tool in this context. To gauge the effects of new regulation,
such studies should accompany all major reform projects.

To avoid regulatory arbitrage, we must take into account the
cross-border effects of regulation. The global financial system needs
global rules. Accordingly, we need to ensure that internationally agreed
measures are transposed into national laws and regulations in a timely
and consistent manner. I strongly support the in-depth implementation
monitoring by the Financial Stability Board and by international
standard-setting bodies as essential tools for maintaining
implementation pressure.

Finally, the crisis has reminded us that containing systemic risk is
vital for safeguarding financial stability. To mitigate and prevent
systemic risks, macroprudential policy frameworks are being implemented
in many countries, including Germany. Since the beginning of this year,
the German Financial Stability Act has been in force. A Financial
Stability Commission comprising representatives of the Bundesbank, the
Federal Financial Supervisory Authority and the German Finance Ministry
has been established. The Commission is in charge of designing
consistent macroprudential policies and held its first meeting just
yesterday. The institutional set-up is fairly advanced. Now, we need to
deepen our understanding of the effects of macroprudential tools and
operationalise their use.

4 Changes to the financial landscape

Although financial sector reforms are not yet complete, it is already
possible to see the impact of new regulation on the financial
landscape. Some banks have fallen off the list of global systemically
important banks because they have simplified their structure, downsized
or de-risked their operations. This also includes a German bank. Several
banks are de-emphasising high-profile but risky capital market business
that benefited employees more than shareholders and society as a whole.
The modified business models should ultimately result in a more
resilient and diversified sector with a more sustainable risk-return
profile.

Further changes to banks’ business models will be brought about by
structural measures. Concerns about institutions’ business conduct built
the political case for such measures, including the ring-fencing or
prohibition of certain activities. Corresponding recommendations have
been made by Paul Volcker, John Vickers and Erkki Liikanen in the US,
the UK, and the EU respectively. While the proposals differ in important
details, they share the same general idea. Deposit-taking credit
institutions should be shielded from the risks of speculative
proprietary trading and high-risk lending. Such a separation of business
lines can play a part in making the financial system more stable and
resilient. But it is not a silver bullet. Ultimately, we should leave it
to bank boards and management to decide what business model is best for
the future. I appreciate that the German legislative proposal on
introducing a ring-fence leaves some leeway in that regard.

Finally, there is evidence that the corporate culture of banks is
changing. Risk management, for example, has gained a more prominent role
in the organisational structure of some banks. Efforts to strengthen
risk governance have been undertaken as well, but further improvements
are necessary. The manipulation of benchmark interest rates by traders
is a case in point. Withholding or clawing back variable parts of
remuneration packages of employees who were involved in such fraudulent
activities can only be a first step. In the future, I expect to see
further changes in institutions towards the promotion of sounder risk
cultures.